PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT

Question No.1 is compulsory.

Attempt any four out of the remaining five questions.
Wherever appropriate, suitable assumptions should be made and indicated in the answer by
the candidate.
Working notes should form part of the answer.
Question 1
(a) Tatu Ltd. wants to takeover Mantu Ltd. and has offered a swap ratio of 1:2 (0.5 shares for
everyone share of Mantu Ltd.). Following information is provided
Tatu Ltd. Mantu Ltd.
Profit after tax ` 24,00,000 ` 4,80,000
Equity shares outstanding (Nos.) 8,00,000 2,40,000
EPS `3 `2
PE Ratio 10 times 7 times
Market price per share `30 ` 14
You are required to calculate:
(i) The number of equity shares to be issued by Tatu Ltd. for acquisition of Mantu Ltd.
(ii) What is the EPS of Tatu Ltd. after the acquisition?
(iii) Determine the equivalent earnings per share of Mantu Ltd.
(iv) What is the expected market price per share of Tatu Ltd. after the acquisition,
assuming its PE multiple remains unchanged?
(v) Determine the market value of the merged firm. (8 Marks)
(b) Following information is given:
Exchange rates: Canadian dollar 0.666 per DM (spot)
Canadian dollar 0.671 per DM (3-months)
Interest rates: DM 7.5% p.a.
Canadian Dollar - 9.5% p.a.
To take the possible arbitrage gains, what operations would be carried out? (8 Marks)
(c) Write a short note on Real Estate Regulatory Authority (RERA). (4 Marks)
Answer
(a) (i) The number of shares to be issued by Tatu Ltd.:
The Exchange ratio is 0.5

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 2 FINAL (NEW) EXAMINATION: MAY, 2018

So, new Shares = 2,40,000 x 0.5 = 1,20,000 shares.

(ii) EPS of Tatu Ltd. after acquisition:
Total Earnings (` 24,00,000 + ` 4,80,000) `28,80,000
No. of Shares (8,00,000 + 1,20,000) 9,20,000
EPS (` 28,80,000)/ 9,20,000) `3.13
(iii) Equivalent EPS of Mantu Ltd.:
No. of new Shares 0.5
EPS `3.13
Equivalent EPS (` 3.13 x 0.5) `1.57
(iv) New Market Price of Tatu Ltd. (P/E remaining unchanged)
Present P/E Ratio of A Ltd. 10 times
Expected EPS after merger `3.13
Expected Market Price (`3.13 x 10) `31.30
(v) Market Value of merged firm:
Total number of Shares 9,20,000
Expected Market Price `31.30
Total value (9,20,000 x 31.30) `2,87,96,000
(b) In this case, DM is at a premium against the Can$.
Premium = [(0.671 – 0.666) /0.666] x (12/3) x 100 = 3.00 per cent
Interest rate differential = 9.5% - 7.5% = 2 per cent.
Since the interest rate differential is smaller than the premium, it will be profitable to place
money in Deutschmarks the currency whose 3-months interest is lower.
The following operations are carried out:
(i) Borrow Can$ 1000 at 9.5 per cent for 3- months;
(ii) Change this sum into DM at the spot rate to obtain DM
= (1000/0.666) = 1501.50
(iii) Place DM 1501.50 in the money market for 3 months to obtain a sum of DM
Principal: 1501.50
Add: Interest @ 7.5% for 3 months = 28.15
Total 1529.65
(iv) Sell DM at 3-months forward to obtain Can$= (1529.65x0.671) = 1026.40
(v) Refund the debt taken in Can$ with the interest due on it, i.e.,

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 3

Can$
Principal 1000.00
Add: Interest @ 9.5% for 3 months 23.75
Total 1023.75
Net arbitrage gain = 1026.40 – 1023.75 = Can$ 2.65
Note: The students may use any quantity of currency to arrive at the arbitrage gain since
no specific amount is mentioned in the question.
(c) Short Note on Real Estate Regulatory Authority (RERA): India has a vast population
with needs regarding food, house and jobs on an ever-increase mode. The housing among
these fields is one of the major ones. Thousands of people have grown to be rich and as
many of them have made loss in real estate business. It is the one of the leading revenue
generators for the government. Even though it has such strong presence in the country, it
never had a regulating body. Due to the failure of the government to observe this, many
people have become the victims of some scheming people doing the real estate business.
The buyers who come from a middle-class background have time and again fallen prey to
such petty real estate developers. There was a growing need to bring a transparent
government body which can check the developers.
Finally, the government delivered by making an authority known as RERA which stands
for Real Estate Regulatory Authority. It was passed in March 2016 by the parliament. This
promises to bring a justice to the buyer through making strict policies that have to be
fulfilled by the developers to sell their projects. The major problem that real estate in India
is facing is that of the delayed possession given to the home seeker by the rich and the
cunning builders. Thus, RERA will help people by bringing in a high level of transparency
and discipline that these builders must have to follow.
The laws under RERA are still in the early days of development but one thing is for sure
that there will be a huge relief for the buyers regarding developer-specific risk. The
mechanism of RERA will be made such that it provides a common ground for both the
buyers as well as the developers. Transparency is the key point regarding the rules under
RERA as the government wants that every aspect of information that the general public
should know should be made available on an informational portal.
The regulatory risk will also be laid upon the developer as he will have to pay compensation
if any mishap happens while giving the possession of a unit. All the builders will have to
register themselves under RERA which will see a low risk in the property business.
Question 2
(a) Consider the following information on two stocks, X and Y.
Year 2016 2017
Return on X (%) 10 16
Return on Y (%) 12 18

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 4 FINAL (NEW) EXAMINATION: MAY, 2018

You are required to calculate:

(i) The expected return on a portfolio containing X and Y in the proportion of 40% and
60% respectively.
(ii) The Standard Deviation of return from each of the two stocks.
(iii) The Covariance of returns from the two stocks.
(iv) The Correlation coefficient between the returns of the two stocks.
(v) The risk of a portfolio containing X and Y in the proportion of 40% and 60%.
(10 Marks)
(b) Sabanam Ltd. has issued convertible debentures with coupon rate 11%. Each debenture
has an option to convert to 16 equity shares at any time until the date of maturity.
Debentures will be redeemed at ` 100 on maturity of 5 years. An investor generally
requires a rate of return of 8% p.a. on a 5-year security. As an advisor, when will you
advise the investor to exercise conversion for given market prices of the equity share of (i)
` 5, (ii) ` 6 and (iii) ` 7.10.
Cumulative PV factor for 8% for 5 years : 3.993
PV factor for 8% for year 5 : 0.681 (6 Marks)
(c) Explain the interface of Financial Policy and Strategic Management. (4 Marks)
Answer
(a) (i) Expected return of portfolio containing X and Y in the ratio 40%,60%
E (X) = (10 + 16) / 2 = 13%
E (Y) = (12 + 18) / 2 = 15%
N
Rp =  X iR i  0.4(13)  0.6(15)  14.2%
i l

(ii) Standard Deviation of X and Y

Stock X:
Variance = 0.5 (10 – 13)² + 0.5 (16 – 13) ² = 9
Standard deviation = 3%
Stock Y:
Variance = 0.5 (12 – 15) ² + 0.5 (18 – 15) ² = 9
Standard deviation = 3%
(iii) CovXY = 0.5 (10 – 13) (12 – 15) + 0.5 (16 – 13) (18 – 15) = 9
𝐶𝑜𝑣 (𝑋,𝑌) 9
(iv) Correlation Coefficient =𝜌= 𝜎𝑥𝜎𝑦
=9=1

(v) Risk of portfolio containing 40% X and 60 % Y

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 5

𝜎𝑝= X 2X 2X  X 2Y 2Y  2X X X Y (X YCorr.XY )

= 0.42 32  0.62 32  20.40.6331

= 1.44  3.24  4.32  3%
(b) If Debentures are not converted its value is as under: -
PVF @ 8 % `
Interest - ` 11 for 5 years 3.993 43.923
Redemption - ` 100 in 5th year 0.681 68.100
112.023
Value of equity shares:-
Market Price No. Total
`5 16 ` 80
`6 16 ` 96
` 7.10 16 ` 113.60
Hence, unless the market price is ` 7.10 conversion should not be exercised.
(c) The interface of strategic management and financial policy will be clearly understood if we
appreciate the fact that the starting point of an organization is money and the end point of
that organization is also money. No organization can run an existing business and promote
a new expansion project without a suitable internally mobilized financial base or both i.e.
internally and externally mobilized financial base.
Sources of finance and capital structure are the most important dimensions of a strategic
plan. The need for fund mobilization to support the expansion activity of firm is very vital
for any organization. The generation of funds may arise out of ownership capital and or
borrowed capital. A company may issue equity shares and / or preference shares for
mobilizing ownership capital and debenture to raise borrowed capital.
Policy makers should decide on the capital structure to indicate the desired mix of equity
capital and debt capital. There are some norms for debt equity ratio.
However this ratio in its ideal form varies from industry to industry. Another important
dimension of strategic management and financial policy interface is the investment and
fund allocation decisions. A planner has to frame policies for regulating investments in
fixed assets and for restraining of current assets. Investment proposals mooted by different
business units may be divided into three groups. One type of proposal will be for addition
of a new product, increasing the level of operation of an existing product and cost red uction
and efficient utilization of resources through a new approach and or closer monitoring of
the different critical activities. Dividend policy is another area for making financial policy
decisions affecting the strategic performance of the company. A close interface is needed
to frame the policy to be beneficial for all. Dividend policy decision deals with the extent of

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 6 FINAL (NEW) EXAMINATION: MAY, 2018

earnings to be distributed as dividend and the extent of earnings to be retained for future
expansion scheme of the organization.
It may be noted from the above discussions that financial policy of a company cannot be
worked out in isolation of other functional policies. It has a wider appeal and closer link
with the overall organizational performance and direction of growth. As a result preference
and patronage for the company depends significantly on the financial policy framework.
Hence, attention of the corporate planners must be drawn while framing the financial
policies not at a later stage but during the stage of corporate planning itself.
Question 3
(a) Herbal World is a small, but profitable producer of beauty cosmetics using the plant Aloe
Vera. Though it is not a high-tech business, yet Herbal's earnings have averaged around
` 18.5 lakh after tax, mainly on the strength of its patented beauty cream to remove the
pimples.
The patent has nine years to run, and Herbal has been offered ` 50 lakhs for the patent
rights. Herbal's assets include ` 50 lakhs of property, plant and equipment and ` 25 lakhs
of working capital. However, the patent is not shown in the books of Herbal World.
Assuming Herbal's cost of capital being 14 percent, calculate its Economic Value Added
(EVA). (5 Marks)
(b) SG Mutual Fund Company has the following assets under it on the close of business
as on:
1st August 2017 2nd August 2017
Company No. of Shares Market price per share Market price per
(`) share (`)
Q Ltd. 2,000 200.00 205.00
R Ltd. 30,000 312.40 360.00
S Ltd. 40,000 180.60 191.55
T Ltd. 60,000 505.10 503.90
Total No. of Units issued by the Mutual Fund is 6,00,000.
(i) Calculate Net Assets Value (NAV) of the Fund.
(ii) Following information is also given:
Assuming that Mr. Zubin, an investor, submits a cheque of ` 30,00,000 to the Mutual Fund
and the Fund Manager of this entity purchases 8,000 shares of R Ltd; and the balance
amount is held in Bank. In such a case, what would be the position of the Fund?
(iii) Calculate new NAV of the Fund as on 2 nd August 2017. (10 Marks)
(c) Discuss what you understand about Embedded Derivatives. (5 Marks)

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 7

Answer
(a) EVA = NOPAT – WACC x Capital Employed.
Capital Employed: ` lacs
Property, etc. 50
Working Capital 25
Patent Value 50
Effective or Invested Capital 125
WACC x CE = 14% x ` 125 lacs= ` 17.5 lacs
EVA = ` 18.5 lacs – ` 17.5 lacs = ` 1 lac
(b) (i) NAV of the Fund
` 4,00,000  ` 93,72,000  ` 72,24,000  ` 3,03,06,000
=
6,00,000
` 4,73,02,000
= =` 78.8366 rounded to ` 78.84
6,00,000

Company 2/8/17 Value

Market Price /share
Q 205 4,10,000
R 360 108,00,000
S 191.55 76,62,000
T 503.90 302,34,000
Total 491,06,000
4,91,06,000
NAV per unit = 6,00,000
= 81.84

(ii) The revised position of fund shall be as follows:

Shares No. of shares Price Amount (`)
Q Ltd. 2000 200 4,00,000
R Ltd. 38,000 312.40 1,18,71,200
S Ltd. 40,000 108.60 72,24,000
T Ltd. 60,000 505.10 3,03,06,000
Cash 5,00,800
5,03,02,000
30,00,000
No. of units of fund = 6,00,000  = 6,38,053
78.8366

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 8 FINAL (NEW) EXAMINATION: MAY, 2018

(iii) On 2nd August 2017, the NAV of fund will be as follows:

Shares No. of shares Price Amount (`)
Q Ltd. 2000 205 4,10,000
R Ltd. 38,000 360.00 1,36,80,000
S Ltd. 40,000 191.55 76,62,000
T Ltd. 60,000 503.90 3,02,34,000
Cash 5,00,800
5,24,86,800
` 5,24,86,800
NAV as on 2 ndAugust 2017 = = ` 82.26 per unit
6,38,053
(c) Embedded Derivatives: A derivative is defined as a contract that has all the following
characteristics:
• Its value changes in response to a specified underlying, e.g. an exchange rate,
interest rate or share price;
• It requires little or no initial net investment;
• It is settled at a future date;
• The most common derivatives are currency forwards, futures, options, interest rate
swaps etc.
An embedded derivative is a derivative instrument that is embedded in another contract -
the host contract. The host contract might be a debt or equity instrument, a lease, an
insurance contract or a sale or purchase contract.
Derivatives require to be marked-to-market through the income statement, other than
qualifying hedging instruments. This requirement on embedded derivatives are designed
to ensure that mark-to-market through the income statement cannot be avoided by
including - embedding - a derivative in another contract or financial instrument that is not
marked-to market through the income statement.
An embedded derivative can arise from deliberate financial engineering and intentional
shifting of certain risks between parties. Many embedded derivatives, however, arise
inadvertently through market practices and common contracting arrangeme nts. Even
purchase and sale contracts that qualify for executory contract treatment may contain
embedded derivatives. An embedded derivative causes modification to a contract's cash
flow, based on changes in a specified variable.
Question 4
(a) An established company is going to be de merged in two separate entities. The valuation
of the company is done by a well-known analyst. He has estimated a value of ` 5,000
lakhs, based on the expected free cash flow for next year of ` 200 lakhs and an expected
growth rate of 5%. While going through the valuation procedure, it was found that the

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analyst has made the mistake of using the book values of debt and equity in his calculation.
While you do not know the book value weights he used, you have been provided with the
following information:
(i) The market value of equity is 4 times the book value of equity, while the market value
of debt is equal to the book value of debt,
(ii) Company has a cost of equity of 12%,
(iii) After tax cost of debt is 6%.
You are required to advise the correct value of the company. (8 Marks)
(b) Mr. KK purchased a 3-month call option for 100 shares in PQR Ltd. at a premium of
` 40 per share, with an exercise price of ` 560. He also purchased a 3-month put option
for 100 shares of the same company at a premium of ` 10 per share with an exercise price
of ` 460. The market price of the share on the date of Mr. KK's purchase of options, is
` 500. Compute the profit or loss that Mr. KK would make assuming that the market price
falls to ` 360 at the end of 3 months. (4 Marks)
(c) Interpret the Capital Asset Pricing Model (CAPM) and its relevant assumptions. (4 Marks)
(d) Explain the difference between Islamic Finance and Conventional Finance. (4 Marks)
Answer
𝐅𝐫𝐞𝐞 𝐂𝐚𝐬𝐡 𝐅𝐥𝐨𝐰 𝐚𝐭 𝐲𝐞𝐚𝐫 𝐞𝐧𝐝 𝟏
(a) Value of the Company = 𝐊𝐜−𝐠
, where Kc = weighted average cost of
capital.
𝟐𝟎𝟎
Value of the company = 5000 =
𝐊𝐜−𝟓
Kc – 5 = 200/5000 = 4%
Kc = 4% + 5% = 9%
We do not know the weights the analyst had taken for arriving at the cost of capital. Let w
be the proportion of equity. Then, (1-w) will be the proportion of debt.
Kc = 9 = w x 12 + (1-w) x 6
9 = 6 + 6w
6w = 3.
Hence w = 3/ 6 = 0.5 = 50 % or 1:1
The weights are equal i.e. 1:1 for equity and debt.
The correct weights should be market value of equity : market value of debts.
i.e. 4 times book value of equity : book value of debts. i.e. 4:1 equity : debt
Revised Kc = 4/5 x 12 + 1/5 x 6= 10.8 %
𝟐𝟎𝟎
Revised value of the company = = 200 / 5.8% = 3448.28 lacs.
𝟏𝟎.𝟖−𝟓

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 10 FINAL (NEW) EXAMINATION: MAY, 2018

(b) Since the market price at the end of 3 months falls to ` 360 which is below the exercise
price under the call option, the call option will not be exercised. Only put option becomes
viable.
`
The gain will be:
Gain per share (`460 – ` 360) 100
Total gain per 100 shares 10,000
Cost or premium paid (` 40 x 100) + (` 10 x 100) 5,000
Net gain 5,000
(c) The Capital Asset Pricing Model was developed by Sharpe, Mossin and Linter in 1960. The
model explains the relationship between the expected return, non-diversifiable risk and the
valuation of securities. It considers the required rate of return of a security on the basis of
its contribution to the total risk.
It is based on the premises that the diversifiable risk of a security is eliminated when more
and more securities are added to the portfolio. However, the systematic risk cannot be
diversified and is or related with that of the market portfolio.
All securities do not have same level of systematic risk. The systematic risk can be
measured by beta, ß under CAPM, the expected return from a security can be expressed
as:
Expected return on security = Rf + Beta (Rm – Rf)
The model shows that the expected return of a security consists of the risk -free rate of
interest and the risk premium. The CAPM, when plotted on the graph paper is known as
the Security Market Line (SML). A major implication of CAPM is that not only every security
but all portfolios too must plot on SML.
This implies that in an efficient market, all securities are having expected returns
commensurate with their riskiness, measured by ß.
Relevant Assumptions of CAPM
(i) The investor’s objective is to maximize the utility of terminal wealth;
(ii) Investors make choices on the basis of risk and return;
(iii) Investors have identical time horizon;
(iv) Investors have homogeneous expectations of risk and return;
(v) Information is freely and simultaneously available to investors;
(vi) There is risk-free asset, and investor can borrow and lend unlimited amounts at the
risk-free rate;
(vii) There are no taxes, transaction costs, restrictions on short rates or other market
imperfections;

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(viii) Total asset quantity is fixed, and all assets are marketable and divisible.
Thus, CAPM provides a conceptual framework for evaluating any investment decision,
where capital is committed with a goal of producing future returns.
(d) Major differences between Islamic finance and other form of finance (Conventional
Finance) are as follows:
Basis Islamic Finance Conventional Finance
Promotion Islamic Finance promotes just, Based on commercial objectives,
fair and balanced society. interest must be paid irrespective
Hence, interest is prohibited. of outcome of business.
Ethical framework Structured on ethical and moral No such framework.
framework of Sharia. Verses
from the holy Quran and
tradition from As-Sunnah are
two divine guidance.
Speculation The financial transactions No such restrictions.
should be free from the
element of uncertainty (Gharar)
and gambling (Maisir)
Unlawful Goods Islamic Finance must not be There are no such restrictions
and Services involved in any transactions not
allowed as per Islamic
principles such as alcohol,
armaments, pork and other
socially detrimental products.

Question 5
(a) Closing values of BSE Sensex from 6 th to 17th day of the month of January of the year 200
X were as follows:
Days Date Day Sense x
1 6 THU 29522
2 7 FRI 29925
3 8 SAT No Trading
4 9 SUN No Trading
5 10 MON 30222
6 11 TUE 31000
7 12 WED 31400
8 13 THU 32000
9 14 FRI No Trading

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 12 FINAL (NEW) EXAMINATION: MAY, 2018

10 15 SAT No Trading
11 16 SUN No Trading
12 17 MON 33000
Compute Exponential Moving Average (EMA) of Sensex during the above period. The 30
days simple moving average of Sensex can be assumed as 30,000. The value of exponent
for 30 days EMA is 0.062.
Provide detailed analysis on the basis of your calculations. (8 Marks)
(b) Punjab Bank has entered into a plain vanilla swap through on Overnight Index Swap (OIS)
on a principal of ` 2 crore and agreed to receive MIBOR overnight floating rate for a fixed
payment on the principal. The swap was entered into on Monday, 24th July, 2017 and was
to commence on 25th July, 2017 and run for a period of 7 days.
Respective MIBOR rates for Tuesday to Monday were:
8.70%, 9.10%, 9.12%, 8.95%, 8.98% and 9.10%.
If Punjab Bank received ` 507 net on settlement, calculate Fixed rate and interest under
both legs.
Notes:
(i) Sunday is a Holiday.
(ii) Workout in rounded rupees and avoid decimal working.
(iii) Consider a year consists of 365 days. (8 Marks)
(c) Explain the advantages of bringing venture capital in the company. (4 Marks)
Answer
(a)
Date 1 2 3 4 5
Sensex EMA for EMA
Previous day 1-2 3×0.062 2+4
6 29522 30000 (478) (29.636) 29970.364
7 29925 29970.364 (45.364) (2.812) 29967.55
10 30222 29967.55 254.45 15.776 29983.32
11 31000 29983.32 1016.68 63.034 30046.354
12 31400 30046.354 1353.646 83.926 30130.28
13 32000 30130.28 1869.72 115.922 30246.202
17 33000 30246.202 2753.798 170.735 30416.937
Conclusion – The market is bullish. The market is likely to remain bullish for short term to
medium term if other factors remain the same. On the basis of this indicator (EMA) the
investors/brokers can take long position.

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 13

(b)
Day Principal (`) MIBOR (%) Interest (`)
Tuesday 2,00,00,000 8.70 4,767
Wednesday 2,00,04,767 9.10 4,987
Thursday 2,00,09,754 9.12 5,000
Friday 2,00,14,754 8.95 4,908
Saturday & Sunday (*) 2,00,19,662 8.98 9,851
Monday 2,00,29,513 9.10 4,994
Total Interest @ Floating 34,507
Less: Net Received 507
Expected Interest @ fixed 34,000
Thus Fixed Rate of Interest 0.0886428
Approx. 8.86%
(*) i.e. interest for two days.
(c) Advantages of bringing VC in the company:
❖ It injects long- term equity finance which provides a solid capital base for future
growth.
❖ The venture capitalist is a business partner, sharing both the risks and rewards.
Venture capitalists are rewarded with business success and capital gain.
❖ The venture capitalist is able to provide practical advice and assistance to the
company based on past experience with other companies which were in similar
situations.
❖ The venture capitalist also has a network of contacts in many areas that can add
value to the company.
❖ The venture capitalist may be capable of providing additional rounds of funding should
it be required to finance growth.
❖ Venture capitalists are experienced in the process of preparing a company for an
initial public offering (IPO) of its shares onto the stock exchanges or overseas stock
exchange such as NASDAQ.
❖ They can also facilitate a trade sale.
Question 6
(a) Omega Ltd. is interested in expanding its operation and planning to install manufacturing
plant at US. For the proposed project, it requires a fund of $10 million (net of issue
expenses or floatation cost). The estimated floatation cost is 2%. To finance this project, it
proposes to issue GDRs.

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 14 FINAL (NEW) EXAMINATION: MAY, 2018

As a financial consultant, you are requested to compute the number of GDRs to be issued
and cost of the GDR with the help of following additional information:
(i) Expected market price of share at the time of issue of GDR is ` 250 (Face Value
being ` 100)
(ii) 2 shares shall underlay each GDR and shall be priced at 4% discount to market price.
(iii) Expected exchange rate ` 64/$
(iv) Dividend expected to be paid is 15% with growth rate 12%. (8 Marks)
(b) Neel holds ` 1 crore shares of XY Ltd. whose market price standard deviation is 2% per
day. Assuming 252 trading days in a year, determine maximum loss level over the period
of 1 trading day and 10 trading days with 99% confidence level. Assuming share prices are
normally for level of 99%, the equivalent Z score from Normal table of Cumulative Area
shall be 2.33. (4 Marks)
(c) Discuss briefly the steps involved in the Securitization mechanism.
OR
Explain the benefits of Securitization from the perspective of both originator as well as the
investor. (4 Marks)
(d) The risk free rate of return is 5%. The expected rate of return on the market portfolio is
11%. The expected rate of growth in dividend of X Ltd. is 8%. The last dividend paid was
` 2.00 per share. The beta of X Ltd. equity stock is 1.5.
(i) What is the present price of the equity stock of X Ltd.?
(ii) How would the price change when:
• The inflation premium increases by 3%
• The expected growth rate decreases by 3% and
• The beta decreases to 1.3. (4 Marks)
Answer
(a) Net Issue Size = $10 million
`10 million
Gross Issue = = $10.2041 million
0.98
Issue Price per GDR in ` (250 x 2 x 96%) ` 480
Issue Price per GDR in $ (` 480/ ` 64) $7.50
Dividend Per GDR (D 1) = ` 15 x 2 = ` 30
Net Proceeds Per GDR = ` 480 x 0.98 = ` 470.40
(i) Number of GDR to be issued

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 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 15

$10.2041 million
= 1.360547 million
$7.50
(ii) Cost of GDR to Omega Ltd.
30
ke   0.12 = 18.378%
470.40
(b) Assuming share prices are normally distributed, for level of 99%, the equivalent Z score
from Normal table of Cumulative Area is 2.33.
Volatility in terms of rupees is:
2% of ` 1 Crore = ` 2 lakh
The maximum loss for 1 day at 99% Confidence Level is
` 2 lakh x 2.33 = ` 4.66 lakh,
and expected maximum loss for 10 trading days shall be:
√10 x ` 4.66 lakh = 14.73 lakhs or 14.74 lakhs
(c) The steps involved in securitization mechanism are as follows:
Creation of Pool of Assets: The process of securitization begins with creation of pool of
assets by segregation of assets backed by similar type of mortgages in terms of interest
rate, risk, maturity and concentration units.
Transfer to SPV: One assets have been pooled, they are transferred to Special Purpose
Vehicle (SPV) especially created for this purpose.
Sale of Securitized Papers: SPV designs the instruments based on nature of interest,
risk, tenure etc. based on pool of assets. These instruments can be Pass Through Security
or Pay Through Certificates.
Administration of assets: The administration of assets in subcontracted back to
originator which collects principal and interest from underlying assets and transfer it to
SPV, which works as a conduct.
Recourse to Originator: Performance of securitized papers depends on the performance
of underlying assets and unless specified in case of default they go back to originator from
SPV.
Repayment of funds: SPV will repay the funds in form of interest and principal that arises
from the assets pooled.
Credit Rating of Instruments: Sometime before the sale of securitized instruments credit
rating can be done to assess the risk of the issuer.
OR

© The Institute of Chartered Accountants of India

 16 FINAL (NEW) EXAMINATION: MAY, 2018

The benefits of securitization can be viewed from the angle of various parties
involved as follows:
(A) From the angle of originator: Originator (entity which sells assets collectively to
Special Purpose Vehicle) achieves the following benefits from securitization.
(i) Off – Balance Sheet Financing: When loan/receivables are securitized it
release a portion of capital tied up in these assets resulting in off Balance Sheet
financing leading to improved liquidity position which helps expanding the
business of the company.
(ii) More specialization in main business: By transferring the assets the entity
could concentrate more on core business as servicing of loan is transferred to
SPV. Further, in case of non-recourse arrangement even the burden of default
is shifted.
(iii) Helps to improve financial ratios: Especially in case of Financial Institutions
and Banks, it helps to manage Capital –To-Weighted Asset Ratio effectively.
(iv) Reduced borrowing Cost: Since securitized papers are rated due to credit
enhancement even they can also be issued at reduced rate as of debts and
hence the originator earns a spread, resulting in reduced cost of borrowings.
(B) From the angle of investor: Following benefits accrues to the investors of
securitized securities.
1. Diversification of Risk: Purchase of securities backed by different types of
assets provides the diversification of portfolio resulting in reduction of risk.
2. Regulatory requirement: Acquisition of asset backed belonging to a particular
industry say micro industry helps banks to meet regulatory requirement of
investment of fund in industry specific.
3. Protection against default: In case of recourse arrangement if there is any
default by any third party then originator shall make good the least amount.
Moreover, there can be insurance arrangement for compensation for any such
default.
(d) (i) Equilibrium price of Equity using CAPM
= 5% + 1.5(11% - 5%)
= 5% + 9%= 14%
D1 2.00(1.08) 2.16
P= = = = ` 36
ke - g 0.14  0.08 0.06
(ii) New Equilibrium price of Equity using CAPM (assuming 3% on 5% is inflation
increase)
= 5.15% + 1.3(11% - 5.15%)
= 5.15% + 7.61%= 12.76%

© The Institute of Chartered Accountants of India

 PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 17

D1 2.00(1.05)
P= = = ` 27.06
ke - g 0.1276  0.05
Alternatively, it can also be computed as follows, assuming it is 3% in addition to 5%
= 8% + 1.3(11% - 8%)
= 8% + 3.9%= 11.9%
D1 2.00(1.05)
P= = = ` 30.43
ke - g 0.119  0.05

Alternatively, if all the factors are taken separately then solution of this part will be as
follows:
(i) Inflation Premium increase by 3%.
This raises R X to 17%. Hence, new equilibrium price will be:
2.00(1.08)
= = ` 24
0.17  0.08

(ii) Expected Growth rate decrease by 3%.

Hence, revised growth rate stand at 5%:
2.00(1.05)
= = `23.33
0.14  0.05

(iii) Beta decreases to 1.3.

Hence, revised cost of equity shall be:
= 5% + 1.3(11% - 5%)
= 5% + 7.8%= 12.8%
As a result New Equilibrium price shall be:
D1 2.00(1.08)
P= = = ` 45
ke - g 0.128  0.08

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